Disruptive Innovation Investing in 2021

3 proven strategies for exploiting technology stock volatility

Edward Iftody
Sep 8, 2020 · 13 min read
What’s wrong with having a little protection? — Image by Sarah Richter from Pixabay

Apple, Tesla, Amazon, Nvidia, Netflix, Facebook … All of these disruptive innovation companies have fundamentally changed their industries, swept away the competition, and now dominate their respective business niche. Even in the midst of a pandemic, these companies have not only flourished, but they have also extended their lead over the competition. I firmly continue to believe these same innovation names will continue to deliver superior returns over the long-term.

However, if you are currently a shareholder of disruptive innovation stocks, you’ve probably been shocked by recent price movements — both on the way up and the way down. Like many investors, you might be struggling with the decision of whether or not to remain invested through this correction.

Whether you’re a long-time investor in disruptive innovation stocks or new to these volatile investments, rather than relying on a buy-and-hold strategy, or on a market timing strategy, I’d like to offer you a third option — an option aimed at maximizing returns and minimizing portfolio standard deviation by exploiting large price movements.

In this article;

  • Innovation stocks are volatile because they are hard to price using traditional pricing methodologies
  • The pros and cons of using an asset rebalancing strategy when investing in disruptive innovation
  • How to capture extraordinary gains and capitalize on unusual under-performance by demonstrating how you can set up your own rebalancing strategy — using many of the same techniques I used for a professional fin-tech platform 15 years ago.

Innovation stocks are volatile because they are hard to price using traditional pricing methodologies

Investing in disruptive innovation (also known as disruptive technology investing) is an inherently risky business. Disruptive innovation investing is risky because these companies are growing quickly but they are also extremely difficult to value. Disruptive innovation necessarily requires a massive amount of re-investment by the company to fuel high growth.

Photo by Priscilla Du Preez on Unsplash

Without massive amounts of re-investment, larger competitors can either enter the new disruptive innovation niche and outspend the contender or simply buy out the new upstart. With the focus on exponential growth to keep ahead of potential competitors, disruptive innovation companies’ obsession with re-investment of profits back into growing the business is absolutely a must.

The flip-side of all that re-investment of profit is, no money for distribution to shareholders (through dividends) and the disruptive innovation company either shows low profitability or even losses — sometimes for years. This makes classic valuation techniques like dividend growth or PE (Price/Earnings) ratios a lot less meaningful than when evaluating more mature, established companies.

This lack of solid price discovery techniques and formulas tends to make disruptive innovation stocks very volatile. Disruptive innovation stocks tend to trade on rumor, on sudden announcements in the news, and on a great storyline that takes hold of the public’s attention rather than on cold, hard facts.

Not unlike the love investors had for the new internet economy story of the late 90s, investors are currently in love with the pandemic growth story. The current story goes; with the world in the middle of a pandemic of unknown length and unknown economic damage, disruptive technology companies allow customers to shop for daily necessities from the comfort and safety of their own homes.

Fair point — but as astutely pointed out by Sean Hanagan, a commenter in a previous article;

The old refrain that ‘it’s different this time’ is actually true but also temporary as the world works through the Covid crisis. Once life and business go back to a semblance of ‘normal’, the outsized impact of quarantine on some company financial performance may well dissipate and disappoint.

That's not to say the pandemic won’t help disruptive innovation companies cement an even greater competitive advantage over their rivals. As Sean goes on to say;

Current circumstances appear to be a great opportunity for firms like Amazon to consolidate gains and make their operations stronger, so companies’ relative positioning within the market may become more entrenched.

However, it’s also important to recognize, storylines can turn against a disruptive innovation stock as well. It may seem crazy now, but only a year or two ago, Tesla struggled with an avalanche of negative headlines and a powerful short-seller narrative that for years convinced investors Tesla was in fact a zombie company — heavily in debt and losing money with no hope of ever turning a profit.

I think the point here is, although disruptive innovation companies will continue to disrupt and grow exponentially over the long-run, stock valuations don’t go in one direction forever. Storylines change and disruptive technology names can fall into and out of favor. Unfortunately for disruptive innovation stock investors — at least in the nearer-term — disruptive innovation names might be temporarily falling out of favor.

The pros and cons of using an asset rebalance strategy

Investing in disruptive innovation at first glance appears to be a risky business — but with a long-term plan, discipline, and strictly followed rules, disruptive technology investments can be tamed to provide superior growth, providing long-term protection from inflation.

What goes up, must eventually come down — Image by StockSnap from Pixabay

Personally, I like to start with equal weighting for all the risky assets I want to manage, regardless of their individual standard deviation. However, you may want to adjust the weighting of each asset depending on risk. For example, you may decide to allocate a smaller amount of money to an extremely risky disruptive technology investment and more money to a more dependable investment.

Next, you should choose a rebalancing strategy that you can reliably follow. Some people may prefer to rebalance semiannually or annually because monitoring your rebalancing is as simple as putting a reminder in your calendar. However, I like to rebalance based on deviation from the original asset allocation. This is a more efficient way to catch big swings in stock prices because it triggers a rebalance when there is an unusual price movement in one or more of your disruptive innovation stocks. (I’ll explain this In more detail later in this article).

Advantages of using rules-based rebalancing

  1. Capture gains – The biggest disadvantage of using a buy and hold strategy with particularly risky disruptive innovation stocks is that although these volatile investments tend to trend higher over time, they also tend to give up short and even medium-term gains just as quickly as they’ve made them. Using a rebalancing strategy is one of the best ways to ensure you capture at least some of these gains and take advantage of some of the opportunities to buy stocks at a lower price when there are unusual losses.
  2. Contrarian – Regular rebalancing will reduce risk slightly in a bull market but it’s worth remembering it will slightly increase portfolio risk in a bear market. I consider this an advantage for investors because the strategy is slightly contrarian (selling high and buying low).
  3. Backtesting — You can test your rebalancing strategy on historical data and compare it to a buy-and-hold strategy to see how much value rules-based rebalancing can add to your disruptive technology portfolio. (More details below)

Disadvantages of using rules-based rebalancing

  1. Trading fees – There’s no way around it, regular rebalancing will cost you trading fees unless you’re using a low-cost or free trading site like Robinhood or Webull.
  2. Taxes – Regular rebalancing will also trigger capital gains and capital loss events. This means you’ll be required to keep track of your transactions, calculate your capital gains, and offset against capital losses each year when you file your taxes unless you’re trading in some sort of tax-free savings account (like the Canadian TFSA). Calculating and paying taxes takes time and of course, forces you to spend some of your hard-earned gains from your portfolio to pay those taxes.
  3. Effort— If you want to set up rules-based rebalancing right, you need to take the time and effort to calculate rebalance tolerances and you will need to periodically re-check those tolerances to determine if a rebalance is required or not. This takes a considerable amount of effort you may not want to invest.
  4. Time — It’s worth noting, rules-based rebalancing will lower overall returns in a bull market and magnify losses in a bear market. However, rules-based rebalancing tends to out-perform over a market cycle. In order to achieve maximum returns, an investor must be prepared to stick to the strategy for 3–5 years. If you don’t have that kind of investing time horizon, this strategy is probably not for you.

How to capture extraordinary gains and capitalize on unusual under-performance

Disclosure: Please seek professional advice before making any investment decisions.

In the early 2000s, my brother and I started working on a cloud-based software platform designed for financial professionals. A key aspect of that software platform was the portfolio monitoring and rebalancing module. To help financial advisors set up rules-based rebalancing for their customers, we did a lot of database research to see what worked and what didn’t. We learned a lot of interesting things working on massive sets of data, but for the purposes of this article, we found 2 key findings;

  1. The less correlation individual securities had to one another, the better.
  2. The best rebalancing strategy requires that rebalance tolerances should be set according to the historical standard deviation of each individual security. However, rebalancing a portfolio regularly once or twice a year was also surprisingly effective over long periods of time.

Choosing low-correlation securities

Out of the two findings, the most important variable to consider when building a disruptive innovation portfolio is to find securities with low correlation to each other. Simply speaking, you want one stock to go up and another stock to go down at the same time. If you can build a portfolio of volatile disruptive innovation stocks with very low correlation to each other, it will increase the opportunities for you to dollar-cost-average into unusual weakness and capture extraordinary gain in each individual stock.

In the following example, I backtested a disruptive innovation portfolio with only 4 ticker symbols. In general, stocks from the same sector will tend to have a fairly high correlation to each other (not so good for diversification purposes). This means investors should take their time to not only research great companies with great future potential — but investors should also look for dissimilar stock market movement.

I’ve chosen 4 disruptive innovation stocks with surprisingly low correlation coefficients — I did this by looking for different capitalizations, the maturity of the business, and industry. Ideally, correlations should be as close to zero as possible. Anything over .5 or .6 is a little too high for rebalancing purposes. PORTFOLIO VISUALIZER

For a rebalancing strategy to be effective, it’s critically important to find disruptive technology stocks that tend to gain and lose value at different times than other stocks in your portfolio. If they all gain and lose value together, the effect of rebalancing will be much lower. To diversify, I suggest looking for more mature companies, newer companies, companies from different industries, … As long as you can find stocks that gain and lose value at different times, rules-based rebalancing should help improve returns substantially, over time (again, roughly 3–5 years). Try to find stocks that have correlation coefficients of 0.5 or lower. The closer you can get to zero (or even slightly negative), the better.

Backtest various rebalancing strategies — figure out what works best for you

Luckily, things have changed a lot over the last 15 years and now there are a lot of free tools online for do-it-yourself investors. After a quick google search, I found this site. After playing around with the site’s ‘backtest portfolio tool’ for 30 minutes or so, I came up with some examples of how much a rebalancing strategy can improve returns and decrease portfolio risk at the same time.

For this example, I used Amazon, Tesla, Microsoft, and Nvidia — each stock allocated 25%. I’ve used 5 years of bull market data until 2019. I initially omitted the 2020 selloff and subsequent Nasdaq bubble to avoid exaggerating the results of rebalancing. (You can find results including 2020 data later in this article).

The results are clear – whether you regularly rebalance the portfolio back to even weightings annually, semi-annually, or quarterly — all three back-tests resulted in better returns than buy-and-hold, with slightly lower overall volatility (standard deviation).

It’s also worth noting, all time-based rebalancing strategies resulted in a far smaller maximum drawdown than a buy and hold strategy, meaning investors were less likely to panic and sell to cash, -38.25% for buy and hold (yikes!), -22.63% for annual rebalancing (not fun), and -18.77% for quarterly rebalancing (a nearly 20% improvement over a buy and hold strategy, with considerably more return).

Buy and hold

Buy and hold — PORTFOLIO VISUALIZER

Annual rebalancing

Annual rebalancing — PORTFOLIO VISUALIZER

Semi-annual rebalancing

Semi-annual rebalancing — PORTFOLIO VISUALIZER

Quarterly rebalancing

Quarterly rebalancing — PORTFOLIO VISUALIZER

The two graphs below include 2020 data. As you can see, the greater the volatility, the greater the performance a rebalancing strategy can add to a portfolio. Rebalancing is really a no-brainer if you want to maximize returns over the long-term.

Buy and hold including 2020 data

Buy and hold through 2020

Rebalanced semi-annually including 2020 data

Rebalanced semi-annually

Again, investors must consider the tax consequences and trading costs of regular rebalancing but it’s clear regular rebalancing significantly improves portfolio returns over time, even if an investor decides to rebalance only once a year, even in a secular bull market.

Rebalancing based on individual stock volatility

Returns can be increased even further if rebalancing is based on the movement of individual stocks rather than regular time-based rebalancing. As a starting point, I like to set tolerances based on the investment’s standard deviation. Generally speaking, the higher the volatility of the individual stock, the higher a rebalance tolerance should be applied for rebalancing purposes.

Again, there are free calculators online investors can use to backtest rebalancing strategies. However, because the volatility of stocks changes a lot over time, using a rebalance-by-individual-stock strategy can be a little more complicated to set up. Therefore, if investors want to try this more sophisticated rebalancing strategy, significantly more time will have to be spent testing over different time periods and adjusting tolerances for each stock.

Due to the complexity of this strategy, I won’t go into it in more detail in this article (contact me directly if you would like to discuss further — if there is enough interest, I will write a separate article dedicated to the topic).

Efficient frontier

Even if you are using a straight-forward, time-based rebalancing strategy, do-it-yourself investors should take the time to use an efficient frontier calculator. 15 years ago, this kind of tool was strictly for professionals only. Today, even beginner investors can use this advanced financial calculator when building a portfolio.

Efficient frontier — Ideally, you should choose an allocation along the steepest part of the curve.

By using correlation co-efficients and historical returns, the efficient frontier calculator can mix and match the securities you want to invest in, to determine the best allocation for each security to maximize return and minimize risk. Once you’ve run this calculator on your sample portfolio (using your preferred historical pricing data), you simply choose a point along the blue line that matches the amount of compounded return you would like to target at a standard deviation you consider acceptable.

In the example above an equal weighting of all four stocks is already nearly on the efficient frontier. However, if I wanted to increase or decrease risk, I could move my mouse pointer along the efficient frontier (in the calculator), and the calculator would tell me how to re-allocated my four stocks to achieve an optimized risk/return balance.

The best portfolio on an efficient frontier is indicated as the tangency portfolio. The tangency portfolio is the most risk/return efficient portfolio on the entire efficient frontier.

FYI — Tangency portfolio in the example — I’ve rounded the numbers to the nearest 5% for simplicity

  • MSFT — 35%
  • NVDA — 20%
  • AMZN — 30%
  • TSLA — 15%

Final thoughts

I sold out my disruptive innovation names very early in the first leg down of the 2020 pandemic-induced selloff. In hindsight, this was a terrible mistake. Had I stuck to my list of diverse innovation technology names, rebalanced into unexpected mid-term weakness, and took profit from unusual mid-term performance, I would be far better off financially than I am now.

The fact is, no one knows with any accuracy what will happen in the technology sector. I suspect technology stocks are going to trade a lot lower. But even if I’m right, it won’t be in a straight line. You could sell at this point, betting the technology sector collapses from here. You could hold your positions, hoping the recent sell-off is temporary and just a natural pullback before an ultimately new high. Or, you could put a rebalancing strategy together and maximize returns in your disruptive innovation portfolio over the long-term by exploiting the continued technology stock volatility.

Thank you for reading. I’d love to hear your thoughts — comment section below. Also, if this article was helpful for you, please pass it on to someone you care about.

Please seek professional advice before making any investment decisions.

Iftody.com

Disruptive Innovation Investing

Edward Iftody

Written by

Edward Iftody is a Communication Coach, author of Surviving Work, a veteran of the Canadian fin-tech industry and a blockchain enthusiast.

Iftody.com

Today’s Most Disruptive Technology Companies and Innovations — Long Form Articles for Investors

Edward Iftody

Written by

Edward Iftody is a Communication Coach, author of Surviving Work, a veteran of the Canadian fin-tech industry and a blockchain enthusiast.

Iftody.com

Today’s Most Disruptive Technology Companies and Innovations — Long Form Articles for Investors

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